INTERNATIONAL BANKING

best practices:

Foreign exchange risk management

As the aftershocks of the credit crisis fade away, U.S. companies have resumed their pursuit of global trade opportunities. Companies are increasing production with overseas partners, importing and exporting goods and services, and pursuing merger and acquisition opportunities. Against this backdrop, more and more businesses are addressing their need for strategic foreign exchange (FX) risk management.

The resurgence of foreign trade — combined with volatility in the global financial markets — heightens the importance of having a foreign exchange risk management strategy in place. After all, FX exposure can significantly influence a company’s accounting and economic activities and affect the strength of its bottom line.

A strong FX strategy begins with a clear framework. It should include:• Identification of specific risks and how

they impact financials• Measurement and collection of FX risk data• Management of the identified risks • Definition and evaluation of the

program’s success

This paper provides a number of recommendations and best practices to help you develop a plan to manage the foreign exchange risk your company faces.

ExEcutivE Summary

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Why hedge?

There is a common misperception that hedging is about making money. The real purpose of a hedging program is to diminish volatility in earnings and cash flow.

The growth of international trade, combined with the recent volatility in global markets, has heightened the need for foreign exchange risk management. but, while a hedging program should not be confused with a profit center, an active yet prudent risk management plan can add value. The reason: hedging allows managers to focus on maximizing the operating value of their firm while minimizing the financial disruptions caused by market fluctuations.

In fact, academic research by Allayannis and Weston (2001) concluded that the hedging premium for public companies — defined as a higher firm value — can be as much as five percent. It is not just public companies that hedge; U.S. companies of all sizes now conduct business overseas, and their numbers are growing.

According to the U.S. International Trade in Goods and Services Reports1, exports of U.S. goods and services in 2011 rose 14.5 percent to $2.103 trillion, up from $1.838 trillion in 2010. For the month of December alone, U.S. exports of goods and services were 9.0 percent higher than in December 2010 and imports increased 11.3 percent over that same period.

This pick-up in overseas activity amplifies not only the need for FX risk management, but also the need for a successful program. Such programs require a disciplined strategy to manage FX risk in an orderly manner, and that begins with a defined methodology to understand and manage the financial implications of your company’s international operations and expansion plans.

A successful hedging program mutes volatility in the value of earnings and the cash generated overseas.

1 This report is issued by the Department of Commerce’s U.S. Census bureau and the bureau of economic Analysis.

Develop The FrAMeWork —polICy AnD proCeDUre

Hedging programs, while not universal, are becoming increasingly popular among global companies. A March 2012 J.P. Morgan survey conducted among large corporations in Japan, Europe and the U.S. revealed that global customers had already hedged approximately 46 percent of their 2012 FX exposure and 13 percent of their 2013 FX exposure.

The framework for a successful FX risk reduction strategy is based on the creation of a board-approved policy, and it ends with the execution of that policy.

The formation of such a policy should be guided by five key elements:• Definition of the hedging objectives • establishment of risk management procedures • Definition of the term and percentage exposure to be hedged• Agreement as to the permitted hedge instruments• Delegation of the authority for hedging decisions and execution

In general, the implementation of a policy will involve a number of best practices. These should include:• Identification of the FX risks• Central measurement and data collection• Management of global FX exposures• Utilization of all prudent hedging tools, including forwards and

options• Determination of the criteria for defining the success of the

program

In the sections that follow, we will look at the best practices for each element of the framework.

2 | beST prACTICeS: Framing the challenge in foreign exchange risk management

identify risks if there are plans to sell overseas assets. The translation of a subsidiary’s income statement, however, is significant. It is also difficult to hedge. however, this risk may be addressable through the proper application of a forecast risk-hedging program.

To understand how the different risks impact the development of a hedging program, we will take a closer look at each.

Forecast risk and cash flow hedging Forecast risk involves future transactions where revenues will be denominated in one currency and expenses in another. The risk has to do with the ultimate accuracy of the forecasts for future currency exchange and how it affects future margins. This can cause the realized value of receipts to vary significantly from the amount that was budgeted. It can also lead to differences in period-over-period comparisons. This risk would arise, for example, when a U.S. manufacturer exports its products to germany and receives payment in euros (eUr) at some future date. between the time a sale is projected and the time at which the sale is made, profit margins will vary with changes in the eUr/USD exchange rate.

hedge accounting treatment is essential in avoiding such earnings volatility. In the absence of cash flow hedge accounting, the hedge instrument would have to be revalued at each accounting period (affecting earnings) prior to the time the sale is recognized. Cash flow hedge accounting enables the earnings impact of the hedge instrument to be matched up with the exposure recognition in the income statement.

FX risk arises in one of four ways, as the chart below demonstrates.• Forecastrisk• Revaluationriskformonetaryitems• Foreigndenominatedcashrisk• Earningstranslationrisk

The first two exposures, forecast risk and revaluation risk, are transactional in nature. They apply to the full cash and earnings cycle, running from the initial budget to the final cash collections and payments.

With forecast risk, budgets are exposed to assumptions that need to be made about the exchange rates that will be in effect as future foreign revenues or expenses are generated. As the forecasts are replaced by actual results, and the foreign receivables and payables are recorded on the financial statements, the result of currency volatility is transaction remeasurement risk that impacts current earnings.

The other two categories of FX risk — foreign denominated cash risk and earnings translation risk — are translational.

The translation of a subsidiary’s balance sheet is generally not a key risk unless there is substantial foreign currency cash held at the subsidiary or

FX risk arises in different ways. Each type of risk has a different impact on a company’s financial results.

Forecast Risk

Cash Flow Hedging

Revaluation Risk for Monetary Items

Balance Sheet Hedging

Foreign DenominatedCash Risk

Balance Sheet Translation

EarningsTranslation Risk

Income Statement Hedging

TRANSACTIONAL RISK TRANSLATIONAL RISK

UNDERSTANDING RISK: THE FOUR TYPES OF FX RISK

Translation at Consolidation

Strategic/long term Automatic rolling program Immediately identifiable exposure Minimized via forecast program

CONSIDERATIONS FOR IMPLEMENTATION

Earnings and cash risk Earnings and cash risk Cash risk Earnings risk

Use of Cash/Repatriation

Cash Flow Sale/Expense Budget

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Many companies believe that pricing a forecasted transaction with a foreign customer or supplier in USD does not incur FX risk since they are denominated in USD. but this view may be an illusion. In reality, the risk has simply been transferred to the customer or vendor.

Consider the case of an overseas vendor who accepts payment in USD. That vendor will have to sell the USD received in payment and purchase local currency to cover its costs. If FX rates shift, the vendor may attempt to get a price adjustment for a shortfall. over time, the vendor may seek to raise its prices or may just be unable to supply the product to foreign buyers. In short, the transfer of risk to the vendor is real. Therefore, a better solution may be to pay the vendor in the local currency and manage the FX risk. This would leave the importer in control of the exposure rather than at the mercy of the vendor’s ability to deliver as promised.

revaluation risk and balance sheet hedgingMost companies begin hedging their transaction exposure as it relates to current earnings and near-term cash generation. because changes in value of transaction exposures due to FX are reported in current earnings, cash flow hedge accounting is not required or desirable. Typically, a short-dated forward contract is an effective hedge in these situations. Forwards are simple to execute and flexible enough to be rolled over into a new hedge at the end of the period — and for a different amount if warranted by changes in the notional of the exposure. online tools, such as Morgan Direct Commercial, can make this recurring process more efficient. longer-dated exposures, such as intercompany loans, may also be hedged through the use of forward contracts that have a longer maturity or through cross-currency swaps. Finally, exposures in high-yield currencies require additional analysis before they can be addressed through forward contract hedges.

Foreign denominated cash risk The next two risk categories (depicted in the chart on page 2) refer to the impact a foreign subsidiary has on a parent company’s balance sheet and its income statement.

In such cases, when the parent company consolidates its financial results, it will have to translate its foreign subsidiary’s balance sheet and income statement into USD. Due to FX rate movements between accounting periods that translation will result in a gain or loss in the parent company’s financial statements. however, the translation of the balance sheet exposure — of the net investment — does not impact earnings. The gain or loss will be reported as an entry that affects equity.

hedging net investment translation risk is less common than hedging the other risks we have mentioned because it does not create earnings volatility. Companies that do hedge this type of risk do it to protect the USD value of foreign cash held on a subsidiary’s balance sheet. They will hedge in anticipation of a future dividend or against the USD value of the entire net asset when the divestiture of an overseas operation is planned.

net investment hedge accounting allows the hedge to be marked to market and reported in equity, bypassing any earnings volatility from hedging this type of exposure.

Earnings translation risk earnings translation risk exposure arises with the translation of a foreign subsidiary’s income statement. Since hedge accounting is not available in this situation, it offers a special challenge. As previously noted, this type of risk can often be managed with a hedge of the anticipated cross-border cash flows through the forecast risk program.

Transaction exposure involves receivables, payables, cash or repayable intercompany loans — denominated in a nonfunctional currency — that need to be revalued when reported as earnings.

Cash flow hedge accounting impacts balance sheets rather than the income statements over the life of the hedge.

4 | beST prACTICeS: Framing the challenge in foreign exchange risk management

measure and collect data

While a U.S. parent may own foreign interests and have subsidiaries that report in their local foreign currency, it is important to conduct analysis on a consolidated basis — and at the parent level. When risk is measured at the parent company, the risk management function becomes centralized and USD-centric. This approach offers a clear advantage to the company.

by addressing all sources of FX risk it faces, a company is able to:• Maximizetheuseofthenaturaloffsetsthatariseacrosstheenterprise• Increasethecontrolofoffshorehedgingactivity• Minimizetransactioncosts

risk management can be less effective when it is decentralized. Assume a U.S. parent has a subsidiary in germany with eUr-denominated sales and expenses, which leads to eUr-denominated earnings and free cash flow. From the parent’s USD perspective, this represents a “long” eUr exposure.

but the subsidiary may view the risk differently. If the subsidiary’s operating management is measured in terms of eUr-denominated results, it will be disinclined to hedge risk, leaving the parent exposed to earnings volatility.

The example becomes more complicated if we assume the subsidiary also has some USD-denominated sales. given the parent is already long in terms of eUr exposure, should the parent allow the subsidiary to hedge the expected USD-denominated revenue — sell USD and buy eUr? Such a trade would actually add to the overall consolidated risk of the firm; therefore, the subsidiary should not enter into the trade. Situations like these emphasize the need to consider all risk exposure within a hedging program, whether it lies at the parent or subsidiary level.

collect the risk dataCompanies with highly developed risk management practices tend to think about the organization of their data in the following way:

BAlAncE SHEEt RiSk• Transaction risk data is integrated into the monthly accounting process

in order to hedge effectively.• generally, the booked transaction risk is fairly easy to identify. The

revaluation of the underlying exposures themselves affects earnings, and unexpected gains and losses are thoroughly investigated.

FoREcASt RiSk• Forecast risk data is integrated into the quarterly or annual budget

process.• Forecast risk can be problematic, especially if a series of foreign

acquisitions has left a company with numerous reporting systems around the world.

• Sales and expense data, listed by the currency in which those transactions will take place, is gathered before a full forecast hedge program is implemented.

While the new processes may take a budget cycle or two to fully implement, the real FX exposures faced by a company will be highlighted if forecasted data is regularly collected.

FX risk is nuanced — the way it is incurred will affect different aspects of a company’s financial operations.

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manage risk

As noted earlier, an approved policy for hedging program procedures provides guidance for FX risk management.

While some questions may be related to “control” issues — such as who can hedge and how large of a trade will be allowed before additional approvals are necessary — four of the most important questions to address include: • When should a company hedge?• how much discretion should an FX policy permit?• how far out into the future should a company hedge?• What hedging tools should be utilized?

When should a company hedge? Some companies lock in the exchange rates related to an annual plan. The following year, the cycle is repeated, and the next twelve months’ worth of risk is covered with a strip of twelve monthly hedges. This approach effectively locks in the plan for a year and creates a greater level of certainty in operational results for that year.

The downside to this approach is that it leads to what is referred to as a “cliff effect.”

To avoid the cliff effect, many companies use a rolling and layering strategy, which is also known as dollar-cost averaging. This approach is recommended because it reduces the potential volatility in earnings and cash. The rolling and layering approach involves first choosing a hedge horizon and the percentage of the exposure to hedge each period. The hedge horizon is typically between six and eighteen months, depending on factors such as the accuracy of the forecast, the ability to change prices and the competitive environment. As trades settle, the desired hedge ratio is maintained by layering in new contracts.

For example, at the inception of a typical rolling and layering program, a percentage of each quarter’s exposure will be hedged within a predefined range. The nearest quarter may be hedged between 50 and 80 percent for each month, and the next quarter may be hedged between 40 and 70 percent. This will continue to the maximum hedge horizon. At the end of each quarter, each month’s exposure is then adjusted to the predefined hedge percent.

once the program is active and as each month’s hedges mature, the result will be calculated as the average of four rates: one from four quarters ago, one from three quarters ago, one from two quarters ago, and one from the prior quarter. over time, this results in dollar-cost averaging and helps smooth out any unevenness in the program’s bottom-line results. This eliminates the need to ask: “Is this a good time to hedge?”

HEDGING ONCE A YEAROne-Year “Back to Budget” EUR Hedging Program

Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, February 2012.

2/02 2/03 2/04 2/05 2/06 2/07 2/08 2/09 2/10 2/11 2/120.80

1.10

1.40

1.70

■ Spot ■ E ective Hedge Rate

A SMOOTHER RIDEOne-Year Rolling EUR Hedging Program with Rolling and Layering

0.80

1.10

1.40

1.70

■ Spot ■ E�ective Hedge Rate

Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, February 2012.

2/02 2/03 2/04 2/05 2/06 2/07 2/08 2/09 2/10 2/11 2/12

In addition, companies that choose to execute hedges monthly rather than quarterly would follow the same rolling and layering plan, but would also have more hedges built into the eventual average rate.

locking in the rate on an entire year’s worth of cash flow, which is executed on a single date, results in a rate that may be an “exceptional” rate or an “undesirable” rate when compared to the hedge rate for the following year. this predicament is illustrated in the graph above.

Dollar-cost averaging can smooth out the potential impact of fluctuating rates.

6 | beST prACTICeS: Framing the challenge in foreign exchange risk management

How much discretion should an Fx policy permit?policies that mandate discipline when hedging forecasted cash flows, yet allow for some degree of discretion, are generally recommended. Discretion is especially recommended in terms of:• Whether the company hedges between the minimum required by its

policy and the maximum allowed in any given month • When the company determines it is time to add a layer

The chart below illustrates discretion allowed in a forecasted cash flow hedging program. How far out into the future should a company hedge?

each company’s ability to forecast is different and changes over time. however, through the use of the rolling and layering approach, adjustments may be made to the percentages hedged as new information becomes available.

Most companies have sufficient visibility to hedge 6 to 18 months into the future. Companies with long-term projects may need to hedge five years or longer.

What hedging tools should be utilized? A transaction risk (balance sheet) program should generally rely only on forward contracts. Typically, cash is collected or paid rather quickly, and the amounts are known. balance sheet positions in emerging markets require additional analysis (and perhaps the use of an option strategy), since high interest rate differentials can adversely impact hedge results over time.

Where a forecasting program is involved, there is naturally more uncertainty. Therefore, incorporating options products can provide greater flexibility. The flexibility that options bring to a program can be simply stated: protection when the FX rate moves in an unfavorable direction, and participation when the FX rate moves in a favorable direction. This concept becomes more important as the hedge horizon is extended.

options can lead to an increase in market share, improvement in margins, or both. While the benefits of options are easy to appreciate, it is important to consider their associated costs.

GAIN (LOSS) ON HEDGES ONLYOne-Year Hedging Program (%)

Source: J.P. Morgan, March 2012.

M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13

■ Maximum Hedged ■ Minimum Hedged ■ Company Discretion to Hedge

0%

25%

50%

75%

100%

% H

edge

d

Months

When FX rates move in a favorable direction, forward contracts inhibit market gains. options, however, allow participation in such moves.

InTernATIonAl bAnkIng | 7

The left bar chart below demonstrates that the forward contract’s settlement value can incur a loss when compared to the gain (or smaller loss) recorded by using options.

In fact, if you include the earnings impact of the exposure plus the hedge in this analysis, you get an even more interesting cumulative result. The point here is not that options should always be chosen over forward contracts, but rather we suggest that options have the ability to provide a much better outcome than forward contracts over the long term — and the longer the hedge horizon, the more valuable the flexibility offered by options becomes.

The bottom line is that when it comes to choosing between hedging with forwards and hedging with options, forwards lock in a specific FX rate. yet, it is important to note that options turned in the better performance over this time period, as they were able to capture the market’s upside.

OPTIONS VS. FORWARDS PART IForwards (selling EUR) vs. Options (buying EUR puts)

Source: J.P. Morgan, March 2012

■ Forwards ■ ATM Options ■ OTM Options ■ Underlying Result ■ Spot

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

-8

-6

-4

-2

0

2

4

6

8

Y1 Y2 Y3 Y4 Y5

(in millions)

purchased options typically require a premium at inception (although this premium can be paid at maturity). To determine whether or not purchased options represent a better alternative to forward contracts, a comparison needs to be made between:

In this context, it becomes easier to evaluate the choice between forward contracts and purchased options. In fact, in the accompanying charts, recently conducted historical analysis quantifies the comparison.

Companies that used simple purchased options to hedge forecasted eUr-denominated sales over the past five years would have had a much cheaper hedge than they would have experienced with forward contracts.

OPTIONS VS. FORWARDS PART I IForwards (selling EUR) vs. Options (buying EUR puts)

Source: J.P. Morgan, March 2012

■ Cumulative Forward Net of Underlying ■ Cumulative ATM Net of Underlying ■ Cumulative OTM Net of Underlying

0 Y1 Y2 Y3 Y4 Y5

2

4

6

8

10

12 (in millions)

FoRwARD contRActS

• No cash paid up front

• Unknown amount of cash required to settle remains unknown

PURcHASED oPtionS

• Known and limited amount of cash required at inception or at maturity

vs.

An option premium of 4 or 5 percent may seem like a significant outlay for a one-year hedge — until it is compared to how much it can cost to settle a forward contract at maturity.

options resulted in the better performance over this time period, as they were able to capture the market's upside.

8 | beST prACTICeS: Framing the challenge in foreign exchange risk management

the final step: Determine the program’s success

There is a common misconception in hedging that the only good hedge is one that results in a realized gain. We urge you not to fall into this trap. It is not unusual for treasury teams to be challenged by their management after money is lost on a specific hedge. Such reactive behavior has been known to lead to the cancellation of a hedging program at the bottom of a market or even worse an attempt to trade the firm’s way out of a loss. A better approach is to evaluate the effectiveness of a hedge against the gain or loss on the underlying exposure.

While it is desirable to benchmark against an ideal hedge program, most companies do not have the time or resources to complete this analysis. So how do you recognize a successful hedge program? We suggest the following be used as a benchmark:

• BAlAncE SHEEt HEDging PRogRAM — Meetings are no longer needed at your company to discuss outsized, unexpected results in the “other FX gain/losses” line item of the Income Statement.

• FoREcASt RiSk PRogRAM — your Ceo and CFo can read about a weaker USD in The Wall Street Journal and know that your company’s overall budget has been positively (as an exporter) or negatively (as an importer) affected by less than the overall market volatility.

• nEt invEStMEnt PRogRAM — The consolidated USD value of cash (which may be “trapped” in foreign subsidiaries) has remained stable despite volatility in FX rates.

Comparison of any gain or loss on a hedge to the loss or gain on the underlying exposure provides a good measure of the hedge’s success.

ConClUSIon

As more and more U.S. companies pursue overseas

business opportunities, their need for a well-managed

FX risk management policy increases. Such a policy can

protect both the bottom line and the continued strength

of the balance sheet that supports it.

A well-designed FX policy will clearly define the

procedures and goals of the risk management program.

It will also include:

• Alistofapprovedtraders

• Allowablehedgeproducts

• Expectedfrequencyoftrading

• Theamountofdiscretionthatwillbepermitted

When a company has a well-documented FX policy, its

management team can focus on the pursuit of new

opportunities for global expansion. This can be done

without undue concern over how previous cross-border

dealings may inhibit the company’s financial capacity for

such new pursuits.

InTernATIonAl bAnkIng | 9

STAnDArD heDgIng ToolS

FoRwARDS • Allows a company to lock in a fixed exchange rate for a specific

future date• provides 100 percent protection against negative currency

moves, but does not allow for the opportunity to benefit from favorable moves

• no outright transaction cost or upfront USD payment required • Credit or cash collateral may be required

PlAin vAnillA PURcHASED oPtionS • purchased options provide the company with the right, but noT the

obligation, to exchange a specified amount of currency on a specific date at a predetermined rate known as the strike price

• In exchange for this right, the company pays a premium (upfront or deferred)

• purchased plain vanilla options differ from forward contracts in that the company is noT locked into an exchange rate and can thus participate in 100 percent of all favorable market movements

• If the company pays an upfront premium for this right, credit or cash collateral is not required

ZERo-PREMiUM collARS • Zero-premium option based strategy • provides protection against adverse currency fluctuations, while

allowing for participation in favorable moves up to a predetermined participation level

• Ability to execute better than the current forward rate if the market permits

• Flexibility in setting range for protection and participation • best-case and worst-case scenarios are known upfront • Credit or cash collateral may be required

ZERo-PREMiUM PARticiPAting FoRwARD • Zero-premium option based strategy • like a plain vanilla forward, provides protection against adverse

currency moves at a given rate, yet allows for flexibility to participate in favorable moves on a portion of the exposure

• The company gives up some participation in profit for the benefit of being fully hedged

• The company has flexibility in setting the level of protection and/or the percentage of participation

• Worst-case scenario known upfront • Credit or cash collateral may be required

1.37

1.32

1.27

1.22

1.22 1.27 1.32 1.37

No matter where the currency is trading at maturity, the company will execute the FX transaction at the Forward Rate.

1.37

1.32

1.27

1.22

1.22 1.27 1.32 1.37

The company is fully protected from the downside, and can participate in upside to a predetermined level.

Protection Level

Participation Level

1.37

1.32

1.27

1.22

1.22 1.27 1.32 1.37

The company pays a premium for full protection

from the downside, with the ability to participate in

100% of upside.

1.37

1.32

1.27

1.22

1.22 1.27 1.32 1.37

The company is fully protected from the

downside, and can fully participate in upside

on 50% of the exposure.

Protection Level

gloSSAry oF TerMS

10 | beST prACTICeS: Framing the challenge in foreign exchange risk management

Base currency: Foreign exchange is quoted as the number of units of one currency needed to buy or sell one unit of another currency. The currency whose value is set at 1.00 is the base currency.

call option: The right but not the obligation to buy a fixed amount of a particular currency at a predetermined strike rate. The purchaser (holder) of a call option has the right to buy currency at the predetermined strike rate. The seller (writer) of a call option has the obligation to sell currency at the predetermined strike rate if the option is exercised.

confirmation: A communication with the counterparty of a trade that details the relevant data for settlement of the trade. Common types of confirmation include: electronic (e-mail or over a system), verbal (phone), mail (letter, memo), or fax.

currency appreciation: A rise in the value of one currency in relation to another.

Deal date: The date on which two or more parties enter into a contract. The deal date is also referred to as the contract date or trade date.

Expiry (date): The last date or only date on which an option can be exercised.

Forward: Actual exchange of currencies where settlement takes place more than two days after the trade at a fixed rate. The forward price is comprised of the spot rate plus the forward points.

Forward points: points calculated from the interest rate differential between two currencies, which is added to or subtracted from the spot rate. Forward points compensate the buyer of a higher-yielding currency so that there is no economic difference between buying the foreign currency forward vs. buying the foreign currency spot and putting it on deposit.

FX swap: Spot foreign exchange transaction simultaneously reversed by a forward contract. The difference in rates reflects interest rate differentials between the two currencies.

Hedge: The forward sale or purchase of a foreign currency (or the execution of an option strategy) to reduce the exchange risk exposure connected with the assets or liabilities (or forecasted transactions) denominated in a foreign currency.

Mark to market: To calculate the fair value of a derivative instrument based on the current market rates or prices of the underlying exposure.

Maturity date: The settlement date or delivery date agreed upon for a forward contract.

non-deliverable forwards (nDFs): Synthetic forwards that entail no exchange of emerging markets currencies at maturity. nDFs exist due to tight currency controls from government regulations. The settlement occurs in U.S. dollars and is based on the difference between the agreed contract rate and the market reference rate at maturity.

Put option: The right but not the obligation to sell a fixed amount of a particular currency at a predetermined strike rate. The purchaser (holder) of a put option has the right to sell currency at the predetermined strike rate. The seller (writer) of a put option has the obligation to buy currency at the predetermined strike rate if the option is exercised.

Settlement date: The date on which currency is exchanged or delivered, or on which a contract settles (also called value date).

Spot trade: Actual exchange of currencies where settlement takes place two days after the trade date. (In Canada, spot trades settle one day after the trade date.)

volatility: A measure of uncertainty. The higher the uncertainty is, the higher the price of an option.

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Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues

May 2013 http://knowledge.wharton.upenn.edu | www.pwc.com

PricewaterhouseCoopers LLP | Knowledge@Wharton Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues 2

Why? Because the CFO determined that, although the hedge would protect all the cash spent in the foreign jurisdiction against currency exposure, the cost of capital — in this case borrowing in external markets — “would be negatively impacted by the inability of some analysts to understand the reporting issues involved,” Rhodes explains. “The concern is that, although many analysts would immediately grasp the sophisticated currency-hedging procedures that were key to the plan, others might not.”

In this case, at least, the CFO decided she would accept variability in cash costs rather than risk misunderstanding or instability in reported results that could potentially disrupt access to cheap debt financing.

If management makes the right move but doesn’t communicate it properly, the wrong signal may be sent to the marketplace, Rhodes adds. “It may seem counter-intuitive at first, but if analysts and investors don’t understand what the firm’s doing,

a company’s stock price may suffer even if the hedging actually helps the firm.” So, even though hedging itself is a tool — neither intrinsically good nor bad — “the direct costs and benefits of the strategy have to be weighed against the impact on investor relations.”

Put another way, answering the question “to hedge or not to hedge” is more than a straight-forward mathematical decision. “There is no simple answer,” notes Catherine M. Schrand, a Wharton accounting professor. The idea behind currency hedging involves reducing or eliminating risk, but the cost involved and the ability to achieve the aims needs ongoing consideration. “The risks, from political uncertainty, to global funding flows, to the timing of revenue collections and other transactional activity, may be difficult to predict.”

An increasing volume of cross-border activity, coupled with rising currency volatility, is forcing many multinational companies (MNCs) to think harder about exchange rate exposure and the way that investors react to the use of currency hedges and other derivatives. For example, a recent press release from the CFA Institute, which oversees the Chartered Financial Analyst designation, notes that derivatives “are prone to leaving investors with a lack of understanding of associated risks and unable to anticipate potential losses if they are not disclosed properly.”

Currency Hedging: The Risks and Benefits Aren’t Limited to Financial IssuesWhen a publicly held company engaged in a multi-billion dollar investment in an overseas location recently, the firm considered using a hedge — or swap — contract to reduce the risk that a big currency swing would impact costs and financial results. The plan was sound financially. Yet, management had concerns about the reaction of investors to this approach and decided to drop the hedging plan, says Chris Rhodes, accounting advisory services partner at PricewaterhouseCoopers (PwC).

“The risks, from political uncertainty, to global funding flows, to the timing of revenue collections and other transactional activity, may be difficult to predict.”

—Catherine M. Schrand

PricewaterhouseCoopers LLP | Knowledge@Wharton Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues 3

Of course, savvy analysts and investors don’t have a problem understanding sophisticated hedging and other strategies, but as hedge-use grows — more than 100 MNCs ranked the risks brought on by currency hedging as their biggest concern, ahead, even, of liquidity risk and counter-party risk, according to a July 2012 Barclays Bank Plc Global Risk Survey — efforts are being made to ensure that more people have a good grounding in these issues.

Stacking the Costs

Costs can add up quickly, too. “A company will have to hire staff to collect information from subsidiaries and to crunch data, and to maintain relations with a variety of brokers and broker-dealers,” Schrand says. “The outlays can quickly become a large fixed cost, so bigger firms are generally more likely to hedge since they can amortize the costs over a larger base.”

And not all of the many issues requiring consideration relate directly to the economics of hedging. Another perceived risk, particularly for investors, is incentive asymmetry, or at the least the appearance of it, says Rhodes. “Say you represent a pension fund that’s invested in a stock. You want management to have a 20-, 30- or 40-year time horizon, but what if they appear to have a shorter horizon?”

The challenge is that some investors may view the short-term nature of hedge programs as one more example of management’s preoccupation with short term results, similar to investors’ complaints about managers who obsess over quarterly earnings. But the issue is deeper than that, Rhodes adds, since the short-term nature of budget cycle hedges should be considered in light of how they fit into a company’s long-term plan.

Budget-cycle hedging, for example, is useful for managing issues like short-term swings and liquidity that are commonly associated with near-term planning purposes. But what happens when the business design encompasses structural long-term exposures, such as a

revenue base that’s tied to the euro but also has funding sources that are in U.S. dollars?

In a case like that, the short-term benefits of the hedge are indeed limited to the maturity of the hedge, but by rolling the hedges, or updating them periodically, management also addresses the long-term exposure issues. That may not be immediately apparent to outsiders, however, so investors will need to understand both the long- and short-term profiles, and how management approaches each.

In fact, Wharton finance professor Wayne Guay thinks that the potential for a misalignment of managerial vs. shareholder incentives is not as likely now as it once was. In many cases today, most components of management compensation are “stocks and options that vest over a period of years…. Because their portfolio is tied to the long-term stock price of the company, management is more likely to think long-term, aligning their interests with those of investors.”

Walking and Talking the Talk

For many companies, the key operational considerations for hedging include why the company is hedging in the first place and how the transactions relate to the core business, Rhodes says. Other prominent issues include the profit margin and credit profile. “Some or all of these issues should be part of the decision-making process. But it really boils down to two elements: How good are you at hedging, and how good are you at explaining it?”

Hedging can be the “hinge” that connects historical cost accounting with fair value concepts, Rhodes says. This idea comes out of accounting regulation ASC 815 (formerly FAS 133), wherein a change in the market value of any derivative — a hedging instrument being but one example — is offset against the change in market value of the underlying asset or liability. Typically, those items are carried on the balance sheet at historical — or acquisition — cost. Changes in the value of the derivative

PricewaterhouseCoopers LLP | Knowledge@Wharton Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues 4

and underlying instrument then get reported in another section of the financial statements — in the earnings statement. So, while hedging offers economic benefits, it can also complicate score-keeping — or financial reporting — particularly for publicly held companies that must make extensive disclosures.

There’s “incredible complexity” when it comes to hedging, says Guay. “Often, there’s a tradeoff between a company’s efficiency in hedging and the understanding that’s communicated to investors. If the hedging tools are so opaque that investors don’t understand how the firm works, then it may be better in some cases to back off on the use of complex hedging.”

That “introduces another layer to the discussion, expanding it from a numbers-crunching exercise to an investor relations issue,” notes Henri Leveque, leader of PwC’s U.S. capital markets and accounting advisory services. “It adds a unique dimension, where a company has to determine if it can overcome the complexity inherent in the hedging instruments as well as the accounting presentation, and if the firm can explain it in a way that outsiders will understand. You have to know your analysts and how they follow certain elements of your company.”

Some analysts, for example, tend to make judgments and issue reports based on a narrow selection of metrics that they’re comfortable with. He notes, though, that even if the long-term economics and return on equity for a hedge

make great sense, the strait-jacket of financial reporting may jumble the perceptions among some analysts.

“Many of them are able to penetrate the noise and will understand the underlying economics,” says Leveque. “But the ones who don’t will find it difficult to understand the long-term alignment of the executive suite. So your investor relations professionals must be able to tell a story that lays out the really good analysis that the company did as it navigated a complex financial pathway.”

What’s more, it is not simply a matter of getting the analyst community to understand long-term, net-positive results. A company may execute “a perfectly good trade with a clear explanation to support it,” says Rhodes. But when investors raise questions about the transaction, management may be forced to spend “a significant amount of time” figuring out how to correctly display the activity in the financial statements and how to explain it. Although some companies do this very well, others often “miss the angle” in management’s analysis of hedging transactions.

Potential Drag on the Stock Price

How should a company make an overall assessment of a potential hedging transaction? One approach, Rhodes suggests, is to adopt a “four box” decision set — similar to a decision tree — to weigh the pluses and minuses. Imagine a kind of flow chart, where the first “box” poses a “yes” or “no” question that must be answered before moving on to the next box. Each subsequent box also poses a question that must be answered before moving to the subsequent box. The entire process — in this case the decision whether or not to make a hedge — would end if the answer to any question is “no.”

“In box one, a company could determine, based on the specific circumstances, whether a hedge makes economic sense,” he says. If it does, the company can move to box two, where management should “look at whether, on the

“It adds a unique dimension, where a company has to determine if it can overcome the complexity inherent in the hedging instruments as well as the accounting presentation, and if the firm can explain it in a way that outsiders will understand. You have to know your analysts and how they follow certain elements of your company.”

—Henri Leveque

PricewaterhouseCoopers LLP | Knowledge@Wharton Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues 5

face of it, hedging may drive negative investor reaction.” If decision-makers decide that hedging may make sense after the initial consideration of analyst reaction, then the process moves on to box three, where they may decide that hedging not only can make sense but also the company could either: (1) disregard the level of negative analyst and investor reaction; or, (2) disclose the hedging activity with simplified reporting.

Finally, in box four, the analysis may conclude that hedging may make sense and management may decide to disclose the activity using sophisticated hedge accounting, and that the company will invest the time needed to explain its actions in a way that brings clarity to analysts and investors.

“A best-practice approach will generally call for management to gain a thorough understanding of the underlying issues before making the decision to hedge or not to hedge,” says Leveque. “The four-box decision tree can assist in making that decision, and once management has arrived at a conclusion, it’s a matter of communicating the activity to the investment community. The reason: If analysts or investors don’t understand something, their very human reaction is generally to go negative on it. And going negative is likely to have other real economic impacts on this enterprise that frankly may not have been there.”

To illustrate the practical effect on a company, consider two companies involved solely in gold mining that have taken fundamentally different approaches to earning profits and communicating their business model to the public. One company forgoes hedging gold and the other hedges the commodity.

The first company fundamentally offers a gold price pure-play, says Rhodes. “In effect, management is saying, ‘I control a block of

mineral rights for extracting gold. The value of the gold in the ground will either go up or down and I accept that risk. I focus only on getting it out of the ground efficiently with the right equipment and the right people.’” If gold goes up, the company’s stock will likely go up, and vice versa.

The second mining company chooses to hedge. The message here, says Rhodes, “is basically that when you buy my stock, you are not buying the near-term risk of gold. I hedge against the gold that’s in the ground and the price at which I sell it. The only thing you’re buying is how efficiently I can get it out of the ground.” Investors in the first company buy mostly gold risk “with a little bit of operational risk.” Investors in the second company are “buying mostly operational risk.”

It’s a personal choice. Some investors want a company to retain risk, instead of hedging it out, often because of the potential for a higher return. Others may generally favor the industry’s prospects, but prefer to try to lower the risk of large swings in value. All of this used to be left entirely for investors to sort out. But explaining things in a way that analysts and shareholders will understand is increasingly important because accounting regulations now call for more transparency, notes Schrand.

“Early on, accounting rules regarding the reporting of derivatives actually increased volatility among firms’ reported financial results,” she notes. “That was the exact opposite of what companies hoped to achieve with hedging. But developments like the comprehensive income statement have helped to bring more order to hedge accounting reporting. There is some evidence, however, that the term ‘derivatives’ may cause some concern among investors who associate it with undue risk; so companies should be very careful when they describe their hedging activities.”

PricewaterhouseCoopers LLP | Knowledge@Wharton Currency Hedging: The Risks and Benefits Aren’t Limited to Financial Issues 6

In fact improved disclosure is “crucial in allowing investors to make more informed decisions and to ensure that company financial reports communicate key information regarding risk exposures and risk management more clearly,” notes a recent CFA report, User Perspectives of Financial Instrument Risk Disclosures Under IFRS Volume II - Derivatives and Hedging Activities Disclosures.

Best Practices

When the rewards from hedging appear to be too high to pass up, management could invest the time needed to improve on its explanations of its trades. One potential avenue is through meetings or conference calls with analysts and investors, suggests Wharton accounting professor Brian Bushee.

“It would be best to do it at a time separate from regular earnings announcements or other disclosures, so that everyone can focus on the issue and not have it be confounded with

performance numbers or forecasts.” The only downside would be “potential proprietary costs if this is an open meeting, such as a freely available conference call or webcast” where “competitors could potentially listen in and gain competitive information. So perhaps a better venue would be an investor conference, or even a private meeting.”

Private meetings are not necessarily forbidden by Regulation FD (Regulation Fair Disclosure). “As long as the managers of a publicly held company do not give out earnings or sales guidance, and just stick to the details of the hedging strategy, then there would be no problem with a private meeting,” Bushee says. “This is because the managers are not disclosing privileged information, but are simply filling in the ‘mosaic’ of analyst and investor information.”

Some clear lessons in all of this are that decisions about currency hedging are highly case-specific and will vary depending on a company’s individual circumstances. But on balance, hedging is very complex. “Decision makers must talk to the CFO, the CEO and the board, and explain the economics,” Rhodes says. It also takes a material amount of time to know how to “correctly display and explain their strategy” to analysts. An integral part of that: “You must know your analysts, and how are they following” complex derivative transactions.

“Decision makers must talk to the CFO, the CEO and the board, and explain the economics.”

—Chris Rhodes

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Stronger U.S. Dollar Negative Impact of U.S. Dollar for Q1. Over the past few quarters, numerous companies in the S&P 500 have discussed the negative impact of the stronger U.S. dollar on earnings and revenues. This trend continued during the first quarter.

“Total company revenues were $9.3 billion, a decrease of 1% year over year. Excluding the impact of

exchange, first quarter revenues grew 3%, driven by both our Human Health and Animal Health

businesses.” –Merck (May 5)

“Foreign exchange negatively impacted first quarter reported revenues by approximately $729 million

or 7%, and positively impacted adjusted cost of sales, adjusted SI&A expenses, and adjusted R&D

expenses in the aggregate by $197 million or 3%. As a result, foreign exchange negatively impacted

first quarter adjusted diluted EPS by approximately $0.07 compared with the year-ago quarter.” –

Pfizer (May 3)

“Worldwide revenue increased 28% to $29.1 billion or 29% excluding the $210 million unfavorable

impact from year-over-year changes in foreign exchange.” –Amazon.com (Apr. 28)

“Total reported sales of $13.4 billion were flat versus the prior year, as 2% organic growth was offset

by 2 points of headwind from the stronger U.S. dollar.” –United Technologies (Apr. 27)

“Revenue for the quarter landed within our guidance range of $50.6 billion compared to $58 billion in

the year-ago quarter, a decline of 13%. As we had expected, our comparisons to last year were

influenced by the continued strength of the U.S. dollar against foreign currencies. As Tim said, in

constant currency, our revenue declined by 9%.” –Apple (Apr. 26)

“Despite continued challenges in the macroeconomic environment, we delivered operating earnings

of $1.26 per share, even with last year's quarter. Excluding $0.10 per share of negative currency,

operating earnings rose 8%. Sales declined 2%, excluding currency, reflecting the current

environment. The weakening U.S. dollar gave us some relief.” –DuPont (Apr. 26)

“Acquisitions net of divestitures added two percentage points to first quarter sales while foreign

exchange reduced sales by 3%. As a result, our company total sales was $7.4 billion, down 2% year-

on-year.” -3M

(Apr. 26) “Core earnings per share were $0.86, down 3% versus the prior year…This quarter's core

earnings per share results included a net FX headwind of approximately $90 million after tax or $0.03

per share, comprised of a negative spot rate impact of about $230 million, which was partially offset

by a $140 million balance sheet revaluation impact in the base period that did not recur this year.” –

Procter & Gamble (Apr. 26)

“GE had a good performance in a slow growth environment. EPS of $0.21 was up 5%. This includes

$0.02 of headwind due through foreign exchange.” –General Electric (Apr. 22)

“As a result of the ongoing strength of the U.S. dollar, we realized a negative currency impact on our

revenues year-over-year of $762 million or $593 million after the benefit of our hedging

program…Once again, Alphabet revenues by geography highlight both the strength of our business

around the globe as well as the impact that currency headwinds continue to have on our non-U.S.

business.” –Alphabet (Apr. 21)

“In Q3, the FX impact of 3 points on year-over-year revenue growth was generally in line with the

guidance, as the recent weakening in the US dollar created less than 1 point of impact overall and

across segments.” –Microsoft (Apr. 21)

“At gross profit, our comparable margin declined, as we were impacted by currency headwinds, the

effects from North America refranchising and the sale of our legacy energy brands to Monster.” –

Coca-Cola (Apr. 20)

“In regions outside the U.S., our operational growth was 0.6%, while the effect of currency exchange

rates negatively impacted our reported results by 6.6%.” –Johnson & Johnson (Apr. 19)

“Our revenue for the quarter was $18.7 billion. Currency continues to be a headwind to our reported

revenue performance, over 2.5 points this quarter. This is 0.5 point better than the low end of the

range we provided in mid-January, or about $90 million translation benefit.” –IBM (Apr. 18)

“Our revenues for the quarter were roughly flat to last year, including $125 million headwind from

currency and a $5 million impact from the recent events in Brussels.” –Delta Air Lines (Apr. 14) “As we had modeled, our unfavorable foreign currency exchange rate impact in the quarter was

approximately $0.02 per diluted share.” –Bed Bath & Beyond (Apr. 6) We delivered ongoing earnings per share of $2.42, in line with our guidance. And when setting aside

significant currency headwinds, particularly, the devaluation of the Argentine peso, it's essentially in

line with the prior year.” – Monsanto (Apr. 6) “Net sales were $30.2 billion, up 13.6% versus the same quarter a year ago. This increase was largely

due to the consolidation of Alliance Boots for the entire second quarter this year and to sales growth

in our Retail Pharmacy USA division. Foreign currency translation adversely affected sales by

approximately $750 million or 2.4%. This was due to the strengthening of the U.S. dollar.” –

Walgreens Boots Alliance (Apr. 5) “Q3 diluted EPS grew 22% to $0.55, despite significant headwinds from FX.” –NIKE (Mar. 22)